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Wednesday, 12th August 2020
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Evaluating directors’ remuneration policies Back  
A little known EU Commission recommendation addressing directors’ remuneration in public companies, is currently being assessed for implementation in Ireland. While most of the issues raised are broadly in line with existing practices in Ireland, one feature is a recommendation that the report of the remuneration committee should be submitted to the AGM for an ‘advisory’ vote by shareholders, provided 25 per cent of the votes held by shareholders attending the meeting request it. Frank O’Dwyer looks at this report, and at other ways of evaluating remuneration policies and equity based incentive schemes.
The application, to Ireland, of a little known EU Commission recommendation addressing directors’ remuneration in public companies, is currently being assessed. The recommendation, ‘Fostering an Appropriate Regime for the Remuneration of Directors of Listed Companies’ was issued in 2004 and Member States are invited to implement it by 2006.

Most of the issues addressed and requirements introduced are broadly in line with existing law and practice in Ireland.
One interesting new feature is a recommendation that the report of the remuneration committee should be submitted to the AGM for an ‘advisory’ vote by shareholders provided 25 per cent of the votes held by shareholders attending the meeting request it. The concept of an advisory vote would be new to Ireland. Clearly it would allow shareholders to express their views on remuneration policy in a formal forum but the result of any such vote would not be binding on the company.

Ireland is a small country with a small number of world class quoted companies. Every year, as annual reports are dispatched and the AGM season progresses, directors’ remuneration in one company or another attracts the attention of commentators. Sometimes it is base salary and pensions but more often it is the potential value of share based performance plans which take centre stage.

It is ironic that the granting of awards under incentive schemes, and the resultant ‘expense’ disclosed in the accounts attract such attention (and would undoubtedly feature in discussions at AGMs under the EU recommendations) since this is the one area of remuneration where shareholders already have direct input. All share based incentive schemes must be approved by shareholders in General Meeting.

Shareholders receive details of new schemes, for which their approval is sought, in advance of AGMs. The proposed rules are available for inspection. Often the proposals are dealt with in the Annual Report.

The reality is that many individual shareholders do not read, or are overcome by the challenge of understanding some of the information provided. What ordinary or indeed sophisticated investor understands terms such as ‘trinomial model’ or ‘lattice option-pricing model.’ This language is not the choice of individual companies - it is what the reporting standards require.

Neither is it the fault of companies that the volume of paperwork associated with the financial year end and AGM can be intimidating. Commonly annual reports are up to 200 pages long. Indeed, the company secretary of one large Irish corporate recently remarked to me that one of the more frequents complaints of shareholders concerned the environmental cost of sending annual reports, notices of meeting, Chairman’s letter, etc to each shareholder!

In most jurisdictions bodies representing institutional investors have a role in setting guidance for listed companies as to the structure of appropriate remuneration schemes. In Ireland it is the Irish Association of Investment Mangers. The IAIM represents the large asset mangers, all of whom will have shareholdings in companies listed here.

It is neither appropriate nor efficient for shareholders to involve themselves in the operational management of large businesses. The IAIM has consistently held the view that basic remuneration structures for executive directors and senior management is a matter for the remuneration committee of the board. The need is to ensure that remuneration committees are composed of non-executive directors who have an understanding of the markets in which the company competes for key executives.

A global business is a global business whether it headquartered in Ireland, the US or France. Companies are competing globally for key executives and remuneration must be competitive to recruit or retain the best. That is in the interest of shareholders.

Where institutional shareholders take a particular interest is in the structure of equity based incentive plans. Most people are familiar with the concept of share option schemes, giving executives the right to buy shares in the future at today’s price. The right can only be exercised if certain performance conditions are met and it lapses, if not exercised, within ten years. Option based schemes were common until relatively recently. However many companies have introduced Long Term Incentive Plans (LTIPs) more recently.

LTIPs involve the purchase of shares, by the scheme trustees, in the market or the issue of new shares to the scheme. These are held for the executives and will vest only on the achievement of specific targets. In effect the executive is given shares if targets are met.

The principle which IAIM has adopted is that executives gain only when shareholders gain and this is reflected in the types of structure which will be approved. Achieving this objective can lead to a degree of complexity.

Typically the maximum award is divided into two equal components each with separate criteria. The maximum potential is always fixed as a multiple of base salary and IAIM will take that base into account.
Fifty percent of the potential is based on the company achieving financial targets ‑ normally earnings per share (EPS).

If EPS growth exceeds the increase in the consumer price index by five per cent then shares begin to vest in the executives. If EPS has grown by inflation plus 10 per cent then the full award of shares in that component will transfer to the executives.

As the value of any business must be based on maintainable earnings growth EPS based targets ensure that shareholders are achieving real benefit.

The second portion of an LTIP award is normally based on the concept of Total Shareholder Return (TSR). Over the period of the incentive programme shareholders achieve a return principally through dividends and increases in share value. The level of return to shareholders can be measured - but how should it be assessed? Companies operate in different sectors and markets. Some sectors may be buoyant others not. One measure of how well a company is run is to compare its performance to similar businesses.

IAIM guidelines provide for the identification of a peer group of international businesses operating in the same sector as the company. TSR for the business is measured against the performance of its peer group and shares in the incentive scheme will vest in the executives based on that comparative performance. Generally there will be no award unless the company has achieved total shareholder return at least equal to the average of its peers. The maximum award will only vest if performance is in the top 20 per cent of the peer group.

Seasoned investors know that share price can sometimes rise because a sector is ‘in vogue’ or ‘hot’. A high share price will count towards total shareholder return but may not be due to sound fundamentals. For this reason the IAIM will not approve an incentive scheme unless the TSR component comes into operation only if a minimum financial performance is achieved. This is normally EPS growth of CPI plus five per cent.

No incentive scheme can address every possible situation or challenge facing a business. It is important that schemes acknowledge that the right strategy can sometimes result in targets not being met. This could be a large acquisition, significant investment in new markets, etc.

Generally IAIM members will allow the remuneration committee, in consultation with IAIM, to adjust targets in the light of significant new strategies.

Sometimes it is easy to highlight the potential gain to executives under LTIPs. Often the challenging targets are not examined. IAIM approved schemes always focus on reward for executives being conditional on reward to shareholders. Exceptional reward should follow exceptional return to shareholders based on demanding targets.

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